Investing In The Stock Market

While not strictly a stock market related topic, many investors quickly become interested in the subject of tax free municipal bonds.  The reason for this:  the words “tax free.”  While taxes are certainly needed to help keep our civilization running along, nobody really wants to pay more of them than they have to.  Many people have heard of really wealthy people who can live off the tax free returns from their municipal bond portfolio.  Of course, this sounds like an amazing lifestyle, and leads many people to want to find out more about this investment option.

So, what are municipal bonds?  Quite simply, these are bonds floated by local governments to fund public projects and such.  Basically, when you buy one of these bonds, you are lending money to a local government.  In exchange for this, you get paid a certain interest rate.  Since these are local securities, the federal government can’t tax them.  Many times, the income from these bonds is also free from state and local taxes.

photo credit: Jef Nickerson

As you might imagine, if your marginal tax bracket is quite high, the tax savings from these might be quite significant.  These bonds offer much lower pre tax returns, but the post tax return for those will high incomes can make them well worth it.

If you are considering investing in municipal bonds, consider the whole picture.  Figure out what your tax bracket percentage is.  This is the amount you will be paying in tax on income from traditional corporate bonds.  Divided the expected yield of a taxable bond by this amount to get your after tax yield.  Compare this with the rate of return from the municipal bond.  If your tax bracket is likely to remain the same into the future, go with whichever option provides the best overall yield.  For those with lower tax brackets, municipal bonds will probably not be worth it, but it is worth looking into.

So, this covers the basics of buying tax free municipal bonds.  There are many complicating factors when it comes to tax issues, so if you are in doubt, please consult an accountant who can figure out what you really owe.  However, if the taxes work out to your advantage, be sure to take advantage of the savings these bonds can provide you with.